The disruptive influence of FinTech

March 2016 | COVER STORY | BANKING & FINANCE

Financier Worldwide Magazine

March 2016 Issue

The financial services industry has endured a tumultuous decade, with the financial crisis and subsequent fallout taking their toll. Financial institutions are facing increased regulatory scrutiny among a number of other challenges. Public trust and confidence in the sector is arguably at an all time low, and banks and their executives have been hit by sanctions and political rebuke. In light of these issues, financial institutions have faced calls to implement much needed cultural and structural changes.

It is little wonder that consumers and businesses alike have seized upon the opportunities offered by FinTech, a catch-all term for the nascent revolution in the financial services space. FinTech – technology and its application in the wider financial services market – offers a genuine alternative to traditional banking and payment systems offered by financial services firms.

For those tired of the oligopoly of the financial services sector, FinTech presents an exciting, democratising development, offering the tools and services needed to meet the demands of today’s modern market. FinTech and the new technologies offered by services such as Bitcoin are paradigm shifting developments which have, and will continue to, disrupt existing financial systems. Though in many respects FinTech is still in its infancy, it appears poised to enter the mainstream.

Disruption

In recent decades, few industries have been immune to the march of technological progress and disruption. Media, retail and transport are just three of the many sectors significantly disrupted by technological shifts. Banking, on the other hand, has remained relatively untouched. Regulatory barriers have largely kept banking in the status quo. Central banks have maintained a vice-like grip on payment systems; however, technological advancements are beginning to undermine the nature of these payment structures. Depositors, borrowers, investors and businesses seeking capital are increasingly being offered more direct, immediate and cheaper access to one another via FinTech services. This trend presents existing lenders with a number of issues which must be overcome.

Much of the demand for new, more flexible financial products is being driven by so called ‘millennials’. As consumers, we have grown accustomed to cutting out the middle man. Services such as Uber, Airbnb and Kickstarter have all disrupted their sectors, bringing consumers together, bypassing traditional gatekeepers. It is in this spirit that we have seen the explosion of FinTech adoption over the course of the last few years.

According to a recent report from EY, consumers are attracted to FinTech by the more attractive rates they provide compared to traditional lenders. The ease of access to different products and services and a better online experience were further drivers. The simplicity involved in using FinTech products and services was generally the most attractive feature, according to EY.

Much like these other, more ‘social’ forms of transactions, FinTech has become a disruptive new market force. In some areas it has even begun to usurp traditional lenders, as it offers consumers and businesses an alternative to traditional banking solutions. FinTech has evolved in recent years to impact many different banking verticals, including payments, lending, insurance, asset management and equity finance.

Financing the global FinTech industry has jumped six-fold over the past three years.

FinTech could also have an enormous impact on the revenues of banks themselves. A recent report by Santander InnoVentures, the Spanish bank’s FinTech investment fund, suggested that the blockchain (the virtually unhackable technology that underpins all transactions conducted via Bitcoin) could save lenders up to $20bn a year in settlement, regulatory and cross-border payment costs. However, while the blockchain could cut down considerably on red tape, the existence of such a system does pose a threat to traditional banks, which could be left with outdated and unpopular legacy systems if the blockchain and other FinTech developments truly take off and become mainstream.

B2C

The driving force behind the promulgation of FinTech services may well lie with the increasing ubiquity of smart devices. More and more banking and financial services transactions are being completed electronically. As consumers continue to use smart devices, and those smart devices become omnipresent, the number of contactless payments will rise, as Mark Adair, a senior associate at Mason Hayes & Curran, explains. “We are rapidly moving toward a world where all our payments will be facilitated by mobile phone or other smart devices, such as watches and tablets. While shops in the UK and Ireland are already introducing contactless mobile payment through services like Apple Pay, I think in the near future we will see everything being paid for with a tap of our NFC enabled smart device – for example, tapping when we enter and exit a car park, at the train station gates and at the local café.”

Given the increasing usage of smart devices and other contactless payment methods to complete transactions, business to consumer growth seems a natural direction for the FinTech industry. Indeed, as technology and consumer tastes continue to evolve, the market for financial services must keep pace, and learn to evolve. Online payment companies such as PayPal made a huge splash in the 2000s and forced organisations to change the way they viewed consumer payments. FinTech, too, is helping to lead a new revolution. “Consumer payments online still suck most of the time, with users needing to type in usernames, passwords, 16 digits from the credit card and more,” says Erik Engellau-Nilsson, vice president of communications at Klarna. “All that friction is boring and tedious and therefore people drop out, leading to lost sales for merchants. And since this is still not a solved problem for most merchants, this will continue to be an important topic for years to come. “Banking has a similar problem – they have a series of technical obstacles stopping them from giving customers excellent service. Name one person who loves their bank –

it’s hard, because their customer experience, based on legacy systems and legacy thinking, is lagging behind. Because they have no technical debt, and because the design of the solution begins with the user experience, FinTech companies will have the upper hand when it comes to building better services for users.”

In the short term, it appears that much of the focus of FinTech will revolve around the consumer banking space. According to Susanne Chishti, chief executive and founder of FINTECH Circle, this focus on consumer banking can be attributed to the ease with which the business to consumer market can be understood, compared with the business to business market. If banks wish to remain relevant, they have pressing decisions to make. “I see the business to consumer market developing strongly going forward, with retail banks trying to defend their market share while FinTech firms and tech giants will try to unbundle financial services and pick the ‘cherries out of the cake’, focusing on high-margin, highly scalable product and service areas, while leaving the commoditised or low margin services to banks,” explains Ms Chishti. “Banks have the choice of either becoming ‘utilities’ or turning themselves into FinTech companies and building up their own FinTech ecosystems via various FinTech partnership and innovation models, and corporate venturing strategies,” she adds.

FinTech is set to have a lasting impact on how consumers pay for goods and services. Slowly, we are moving away from traditional banking transactions utilising cash or credit cards, opting instead for smart devices and contactless transactions. “ApplePay’s launch in the UK was one of the big news stories for the consumer payments space in the UK last year,” says Angus McLean, a partner at Simmons & Simmons. “With the likes of Apple and the levels of contactless adoption generally now in the UK, it is difficult to see any new start up players breaking into that market. However, there will inevitably be space for advances in the underlying technologies which will present opportunities for smaller FinTech firms.”

Moving forward, those transactions could be completed utilising fingerprint identification or some other biometric mechanism. It is the possibility of revolutionary, and hopefully safe, technological developments which is helping to drive interest. As a result, investment groups have ploughed tens of billions of dollars into the FinTech industry in recent years, in the hope of unearthing the next unicorn, and this level of investment shows no signs of slowing anytime soon. Over the last six years, the size of the FinTech market has exploded, according to data from a joint KPMG/FinTech Innovators report. Financing the global FinTech industry has jumped six-fold over the past three years, with over $20bn estimated to have been invested in the market last year, up 66 percent on 2014, which saw just $12bn.

Culture shock

FinTech has begun to lure young, high income consumers who are often early adopters of new technologies. These early adopters tend to be found in high development urban areas – which also happen to be major financial centres – such as London, Hong Kong and New York. According to a recent survey by EY, 15.5 percent of digitally active consumers have utilised at least two FinTech products in the last six months.

However, it is not just customers that have been drawn to FinTech services. With banks and financial institutions facing increased regulatory scrutiny, organisations are finding it harder than ever to attract and retain talent. This recruitment deficiency has been brought into even tighter focus in recent years with the impressive technological advancements made in the world of banking. The coming of the digital age has raised new questions about the relevance of many traditional financial institutions. Accordingly, would-be employees have been attracted to FinTech organisations, many of which are associated with the kind of working culture for which Silicon Valley is renowned.

Much has been made of the changing face of business in recent years. Tech companies have gained influence and helped to define a new working environment over the last decade. Google, Apple, Facebook and others have created vast working campuses for staff, offering ‘unlimited’ holiday and stock options to prospective employees, among many other perks. This change in corporate culture is designed to attract and retain talent, and the sweeteners offered by software companies and internet giants have had a big impact on their respective industries. FinTech firms are also embracing this new way of working, tempting talent to forsake traditional financial services firms by offering a different working culture and perks. Some of the brightest minds who 20 years ago would have been a staple of the financial services industry, today find themselves in the FinTech space.

But there is more to FinTech companies than simply allowing employees to wear jeans and providing them with free pizza and beer. FinTech firms have also been able to woo investors – and top talent – thanks to their innovative and comparatively bureaucracy-free approach to business.

The changing face of banking

With key talent and investors pouring into the FinTech space, traditional financial institutions must act quickly. Though it is highly unlikely they will be washed into the sea by the rush of FinTech, they are in danger of being outmanoeuvred. So how can banks deal with this threat? In some respects, it would be prudent for organisations to ape FinTech firms. “The FinTech sector is a ‘double-edged sword’ for banks,” says Ms Chishti. “On one side, the FinTech sector and the tech giants that have started to offer financial services and payments are clearly the most disruptive threat the financial services industry has ever seen in its history. On the other hand, FinTech firms provide solutions for banks which can not only speed up the internal innovation and transformation processes of existing financial services players, unlock the power of Big Data internally and most importantly help banks to survive long-term, as many tech firms will start to offer financial services to their existing millions of customers globally.”

Of course, banks have been ‘digital’ for many years, utilising biometrics and blockchain for example, albeit often in the background. However, it is imperative that financial organisations continue to modernise and remove the more cumbersome facets of their businesses. Expect to see financial institutions partner up with FinTech organisations moving forward. Adrian Shedden, a senior associate at Burges Salmon, points out that we are seeing the creation of a “symbiotic relationship” between traditional financial organisations and FinTech firms. “Financial institutions are starting to collaborate with, or acquire, innovative FinTech solutions that can be distributed among their existing customer base,” he says. “These solutions were largely focused on payments solutions, such as ApplePay. Increasingly, however, ‘challenger’ banks, ‘robo’-advice, decentralised ledger technology, and data solutions, started to have their share of the limelight. Key to the last 12 months was a shift from innovation driven by consumer facing solutions to greater engagement by institutional players.”

According to Clare Burman, an associate director at Osborne Clarke, we may see banks working in partnership with FinTech companies and funding the development of the new products that they will need in order to gain a competitive edge. “The involvement of major banks may also reassure consumers who are wary of engaging with less familiar names from the FinTech sector,” she adds.

Another tactic financial institutions may pursue more aggressively is to acquire FinTech companies outright. Clearly, a number of major banks are redoubling their efforts to adapt new technology. According to The Statistics Portal, bank spending on new technologies is expected to reach $19.9bn in 2017 in North America. However, some other financial institutions are turning to tactics employed by the major internet powers when a new and potentially disruptive company enters the market: M&A. The number of FinTech acquisitions climbed 66 percent between 2014 and 2015, according to Pivotl, and it seems likely that activity will pick up again in 2016.

Regulatory developments

As consumers and businesses wake up to the potential of FinTech, so too are government bodies. In July 2015, the US Treasury Department issued a Request for Information for online marketplaces. A recent court ruling in the US regarding the role of banks renting their licences out to marketplace lenders has also raised a number of questions over what form the industry will take in years to come. Discussions around FinTech regulation have not been confined to the US, however, as regulators worldwide begin to engage.

Thankfully, regulators seem to be taking an encouraging approach toward FinTech. “In the UK, the FCA is trying hard to work with the FinTech community in order to ensure that regulation does not stifle innovation,” says Ms Burman. “Project Innovate has already worked with 175 businesses that are developing new products and services, and the FCA’s proposal to launch a ‘regulatory sandbox’ in spring 2016 is a very welcome extension. However, being such a hot space, and with so many new market entrants all wanting to be first to market with innovative products and services, there is a risk that the regulator may find itself overstretched on occasion.”

The FCA says it is receiving requests for assistance in developing similar support from a number of other regulators, globally. “This is just the start, and regulators will continue to seek to maintain the balance between customer protection, innovation and competition,” says Mr Shedden. “They could do a lot worse than by following the UK example.”

The world’s financial and technological centres are also hotbeds of FinTech development. With many of these hubs competing to attract the highest level of investment possible, the task facing regulators becomes even harder. Providing an attractive investment environment is key, but attention must be paid to ensuring that those investments are handled in a responsible manner. “We live in a competitive global marketplace. Governments of major technology and financial hubs like London, Dublin, New York and Singapore are competing to attract the best talent and investment,” says Mr Adair. “Regulators in such jurisdictions face a constant balancing act between ensuring that the money we entrust to FinTech companies is handled responsibly, and trying to avoid suffocating innovation and investment. The main thing that regulators need to recognise is that they cannot simply apply the same rules to FinTech companies that they have historically applied to traditional banks, which often have large in-house compliance teams. Communication and relationship building is key – some form of informal guidance from the regulator on key issues would almost certainly be welcomed by a FinTech company.”

The imminent arrival of the Payment Services Directive (PSD2), some three years after its initial proposal, will threaten the status quo of traditional banking. PSD2 will introduce new rights for third party providers to access bank accounts, the arrival of third party access to accounts, the use of APIs to connect merchant and bank directly, and the ability to consolidate account information in one portal, which will undoubtedly disrupt payment services in Europe. PSD2 represents an important opportunity for FinTech firms, and a potential headache for traditional financial institutions.

Moving forward

It would be foolish to suggest that FinTech will eliminate traditional, institutional banks in the future. They will remain part of the fabric of the international banking sector for decades to come. However, FinTech will continue to disrupt the sector. Accordingly, it is up to traditional banks to become more agile and flexible. Traditional banks may begin to take on more of a FinTech form, offering customers some of the services that helped make FinTech organisations so popular in the first place.

“You only have to look at the proportion of loans on P2P platforms like Lending Club in the US that come from the big banks to see that the lines are becoming increasingly blurred between the early disruptors and the businesses they set out to challenge,” says Mr McLean. “When you add to that the way in which banks like Barclays have embraced FinTech with their accelerator programmes, and the FinTech investments that banks like Santander and HSBC are making through their FinTech VC funds, you realise that the story is a lot more nuanced than it was a couple of years ago.” Indeed, the announcement that the Australian Stock Exchange is developing a blockchain as a replacement for its existing platform for clearing and settling trades is a further indication of the direction in which the financial sector is headed.

The paradigm has shifted. The influence of FinTech is sure to be felt for years to come. Thanks to a perfect storm of changing tastes, market forces and working cultures, FinTech has proved to be a disruptive force in modern banking circles, a trend which looks set to continue.